Imbalances, Competitivenes and Economic Adjustment

EU Balance-of-Payments assistance for Latvia: Foundations of Success

Radoslav Krastev,Francesco Di Comite,Gabriele Giudice,Daniel Monteiro

DG ECFIN – Unit G.2, 1 March 2012

Imbalances, Competitiveness and Economic Adjustment

Introduction

•

Pre-crisis facts: Huge CA imbalance in 2006-07

•

Typical explanation: Too high labour costs

•

Typical policy Implication:

The only ways to recover balances are:

-

devaluation and/or

-

wage cuts

•

Latvian case shows there is much more

2

Outline of the presentation

•

Standard approach of analysing imbalances and competitiveness (REERs, ULC, CA)

•

Supply side analysisGross value added, Sectoral

decomposition; Non-cost/non-price indicators

•

Demand side analysisSavings, decomposition of demand

•

Main findings and policy conclusions

3

Presenter

Presentation Notes

1. Standard approach: Standard indicators (REER, ULC) do not show the whole picture as CA gap widening was not always mirrored by deterioration in REER, ULC; moreover export market shares have been rising on permanent basis => need to expand the analysis of imbalances and competitiveness to structural components and non-price competitiveness on the supply side and more detailed analysis of the demand side

Standard competiveness analysis is based on REERs and ULC. But they cannot fully explain CA dynamics the in pre-crisis period

4

Presenter

Presentation Notes

Changes in REERs in mid-90's and during the crisis in 2008-10 are consistent with CA fluctuations but cannot explain the CA dynamics in 2000-05; still REER ULC is more indicative than REER CPI

Both exports and imports rise at very high rates until 2007

5

Export market shares kept increasing despite rise in ULC

0.00%

0.05%

0.10%

0.15%

0.20%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Latvian export market shares

EU27 Market Shares Global Market Shares

Exports rise in real and relative terms despite increase in ULC

What drove exports, if ULC went up? Need to go beyond labour factors to explain this

6

Presenter

Presentation Notes

Despite the deterioration in the standard competitiveness indicators, exports were rising both in real and relative terms that calls for a more detailed analysis of the supply side competitiveness that goes beyond the traditional concepts of prices and labour costs; There is also a need of an in-depth look at the demand impact on imbalances.

Supply side analysis: Exports

•

Labour

costs matter, but there is much more

•

… need to consider non-labour factors of production: Capital, profit rates, intermediate consumption (energy unit cost, transport unit cost, etc)

•

… and non-price indicators: quality, product differentiation…

•

… and effects across sectors

7

Presenter

Presentation Notes

This approach could be very useful for in-depth reviews under MIPs as it could identify specific factors and sectors that impede competitiveness

How to assess non-labour factors?

•

They can be analysed through GVA identities:

•

Output –

Intermediate Consumption = GVA = P + K + LMore efficient use of energy, transport, etc will result into lower IC and higher GVA;gains could be allocated to P and L with different implications on ULC.(historical data show stable ratio of IC to Output in Latvia but there is strong potential for improvingGVA/unit costs through energy efficiency)

•

Ratios of profit (P) to GVA and capital use (K) to GVA can explain other factors of production not counted in Intermediate Consumption

8

Presenter

Presentation Notes

The ratio of IC to Output was stable in Latvia through the years, so no gains or losses in competiveness can be claimed from factors of production covered by IC. However, there is a potential for improvement by more efficient use of energy, as Latvia has one of the highest intake of energy resources in the EU and imports of primary energy resources account for 50% of the merchandise foreign trade deficit.

Decomposition of Gross Value Added GVA = P + K + L

Profit rates recover

9

Presenter

Presentation Notes

Capital efficiency has improved (use of capital to GVA has declined) in periods of increased ULC that has to a large extent retained the favourable export position in the corporate sector and explains the large profit margins; despite the drop in profits rates in the height of the crisis in 2008-09, they have remained above the EU average; profits have now recovered to LT average showing that competitiveness has been restored; also the slight increase in ULC on long-term basis (2000-10) is offset by the drop in unit capital cost

Why export shares, profits were not hit by higher ULC ? In addition to capital use, we look at

Quality and non-cost competitiveness Focus on Latvian firms' capacity to compete on international markets

Quality estimated as a function of price and cost differentials across countries

10

Presenter

Presentation Notes

This analysis covers only merchandise exports and is based on further disaggregation of sectors to 98 branches. The study explains non-cost factors affecting competitiveness and ultimately the high profit rates in Latvia as demonstrated from the GVA decomposition.

Quality gains (largely) offset labour cost hikes until 2007

Since 2009, both ULC and quality support external competitiveness

11

Presenter

Presentation Notes

Important to stress that indices are calculated for each sector and then weighted for share in total exports to get the overall index.

Sectoral analysis: Labour share in construction surged during the boom, went through a strong correction afterwards but remains above industrial levels

12

Shares of Labour in GVA

Presenter

Presentation Notes

Sectoral approach to ULC shows striking divergences. Construction has contributed significantly to imbalances as the negative impact of growing ULC in the sector was doubled by the increasing share of the sector in GDP. At the same time, industrial labour costs were steadily declining barring a relatively small increase in the pre-crisis period.

Overall labour share in Latvia is now again clearly lower than the rest of the EU

Labour costs drop back to levels well below EU-27 average – the margin could be linked to structural differences, competition, trade unions

But the picture by sectors is quite different

13

Presenter

Presentation Notes

The share of labour in GVA in Latvia drops back to levels well below the total for EU 27 – the margin can be explained by structural differences and lower level of unionisation in Latvia

Diverging trends in Construction and Industry, the latter has now regained a significant margin compared to the EU

14

Presenter

Presentation Notes

However, the pictures are quite different by sectors especially when industrial and construction labour costs are compared with EU-27. An argument could be made that industrial producers have adjusted labour costs too much while construction firms have not adjusted sufficiently

Demand side analysis: Imports, why did they boom? And is that bad?

•

Key identities to track sources of excess import demand:

S – I = CA

GDP = C + I + (X – M) = (Cd + Cm) + (Id + Im) + [(Xd + Xm) – M]

Low saving rates as well as shift in consumption towards imported goods are clear signs of demand driven imbalances

It is important to monitor allocation of imports to GDP components, not all imports are ‘bad’ : Imports directed to investment in export or import substitution sectors may worsen the CA in the short run but improve the balance in the long run; a rise in the import component of consumption (Cm/C) is instead a clear warning sign that imbalances are building up 15

Presenter

Presentation Notes

Cd and Cm respectively indicate consumption of domestic and imported goods and services; Sources of excess demand could be various: as shown in the KS paper, external capital inflows are a key factor for small open economies. However, consumer and saving propensities could be also a big factor

Excess demand boosted imports (and CA deficit) to very high levels during the boom

16

Imports rose well above ‘expected’

levels in 2004-07

17

‘Expected’ real imports as a function of real GDP, relative import prices and lagged imports.Other factors affecting imports: FDI, increased credit flows, mainly from abroad. Private-sector leveraging driven by high growth expectations and favourable credit conditions.Changes in preferences(namely towards foreign, more expensive goods).Perceived wealth, asset price effects affecting consumption

Accelerated credit inflows financed the surge in imports

18

Exceptionally high growth of credit inflows in 2006-07 is clearly correlated to imports

A sudden stop in 2008 weakened import demand

Import of consumer goods grows faster than private consumption

19

GDP = (Cd + Cm) + (Id + Im) + [(Xd

+ Xm) –

M]

C = Cd

+ CmCm grew faster than C

→ Propensity of consumers to buy imported goods (e.g. vehicles) increased abnormally during the boom

Cm

C

Household savings clearly unsustainable before the crisis

20

Presenter

Presentation Notes

Household savings rates are low in general (significantly below the EU levels) and decline steeply to negative rates in the boom years. The government and corporate savings performed well in relation to EU-27 although government spending was also generous in 2007-08. A key policy issue here is how to manage household savings and consumption – the shift of the tax burden towards consumption was definitely the right policy decision implemented during the EU/IMF programme

Concluding evidence•

Latvia's imbalances were mainly demand driven and only to a lesser extent affected by loss of external competitiveness

•

High consumer demand driven by capital inflows, low saving rates of households, and perceived wealth and asset price effects were a major cause of imbalances

•

Supply side factors were largely related to the construction bubble. Both the size of the sector and the share of labour costs in the sector rose substantially

•

Competitiveness seems fully recovered when cost and non-cost indicators as well as profit and capital efficiency are taken into account. However, there are still divergences at sector levels, notably in construction where labour costs remain high while industrial firms came out of the crisis with huge gains in competitiveness.

21

Presenter

Presentation Notes

Latvian overheating model: Large capital inflows, strong growth prospects, easy credit, construction bubble, wages and non-wage price effects on incomes and consumption, supported by wealth effects from increasing house prices, strengthening the propensity to import, leading to an unsustainable external deficit Note that the shift from labour to consumer and property taxes was a key measure implemented during the programme to support the rebalancing of the economy to the tradable sector. At the same time, there is still a potential of further tax rebalancing as excise, environment, and property (both real estate and cars) are still low in relation to the EU average.

Policy Implications•

The standard analysis of competitiveness needs to be expanded to cover demand and supply components, sector indicators and non-labour and non-cost competitiveness indicators

•

Management of capital inflows and savings/consumption remains a major challenge (Given the volatility of household savings and the high sensitivity of the (small open) economy to capital inflows)

•

Policy responses must focus on bank regulations and taxation to provide better incentives, as control on external capital inflows is not an option

•

Policy needs to be sector specific to properly prevent and address imbalances at the source

Thank you for your attention! 22

Presenter

Presentation Notes

Additional notes The shift from labour to consumer and property taxes was a key measure in the EU/IMF programme for rebalancing the economy. However, there is still a potential of further rebalancing as excise, environment, and property taxes (both real estate and cars) are still low in relation to the EU average Finally, investments in energy efficiency provides a big potential for competitive gains, as Latvia has one of the highest intake of energy in the EU and imports of primary energy resources account for about 50% of the foreign trade deficit

Imbalances, Competitivenes and Economic Adjustment

Technology